Debt is a massive burden for many people, both financially and emotionally. Credit card debt, student loans, medical bills—it all adds up fast. To solve this personal finance dilemma, many people turn to a debt management plan. A debt management plan is a program that helps individuals or families get out of debt with a strategy that goes beyond making regular monthly payments. A good debt management plan follows one of two pathways—debt consolidation vs. debt settlement. Each of these options will significantly reduce your debt, but their effectiveness can vary for several reasons.
This blog will show debt consolidation and debt settlement work and how they can work for you. If you’re ready to get out of debt, keep reading.
Types of Debt
Debt consolidation vs. debt settlement—anyone who is thinking about actively eliminating debt faces this argument. When considering what plan is best for you, deciding which accounts you want to manage will be essential. That decision may come down to the type of debt you have. Let’s take a look at the significant kinds of debt:
Secured debt is backed by an asset that the borrower owns that is pledged to the lender. This asset is called collateral. If the borrower fails to repay the debt, the collateral is seized by the lender to recoup their loss. An excellent example of a secured debt would be a car loan—if you do not repay the loan, your bank or credit union would repossess the car and sell it. In addition to putting up collateral, secured debt also requires a credit check to review creditworthiness.
With unsecured debt, you are borrowing money and not using any assets as collateral. The lack of collateral makes unsecured debt riskier for the lender than secured debt. When a lender doesn’t require the loan to be backed by any assets, they trust your reliability to repay the loan. The most common types of unsecured debt are personal loans and student loans. If you don’t pay back the loan by the due date or in full, then your repayment may be increased with interest and fees. Additionally, any late or delinquent payments can hurt your credit score.
Unlike an installment loan that delivers a lump sum cash payment, revolving credit gives you a credit limit that you can use as you please. Your credit limit stays the same regardless of monthly repayments, and all you have to pay is back the funds you use. If you do not repay the total amount by your due date, the balance moves over—or revolves—into a new “loan.” The best example of revolving debt is a credit card. Revolving debt will continue to accrue interest every billing cycle if the debt is not repaid.
The largest form of debt that many people carry is a mortgage. Mortgages are loans that use real estate as collateral. Mortgages are among the safest investments because they have a low risk of default and usually carry lower interest rates than other investments. A typical mortgage has a loan term of 15 to 30 years. The length of the loan depends on whether you want a monthly payment to be comfortably affordable.
Depending on your financial situation, any one of these types of debts can become tough to manage. Poor spending habits, unexpected fees, and changes in income can all affect our ability to repay what we owe. Working with a debt consolidation firm or debt settlement company can bring some much-needed financial relief.
What is Debt Consolidation?
Debt consolidation is a process where you use different forms of financing to pay off other debts and liabilities. Since all debts are combined into a single loan, it often has more favorable terms—lower interest rate, low payments, and more repayment time.
With debt consolidation, you can lower your debt repayment stress by reducing the total number of payments you need to make each month. Consolidation puts different types of debts into one account. This way, you’re only making one payment each month instead of trying to manage multiple due dates and payment amounts.
How To Apply For A Debt Consolidation Loan
To get a debt consolidation loan, you will need to go through an application process like any other loan. You can increase your chances for approval by following the following steps:
Check Your Credit Score
Your credit score is a rating that lenders and creditors have been using to determine your creditworthiness. It is a number based on your overall history of borrowing money (or using credit) and how quickly you repay it. A credit score ranges from 300-850.
Before applying for a bad credit loan, you should know that bad credit (a credit score that ranges from 300-629) will not necessarily disqualify you for a debt consolidation loan, borrowers with higher scores are approved more often than not. If your credit score is bad, you may want to consider taking time to rebuild your credit before you apply for debt consolidation.
Total Your Accounts
List your current debts (credit cards, store credit cards, payday loans, etc.) and calculate the total debt amount. The total is the amount of money you want for your consolidation loan.
Then, total up the monthly contributions you make towards your debts. Your monthly payments need to fit within your budget. Figure out how much you’re paying per month on your debts, then determine if you need to make any spending adjustments to continue your debt repayments. The new loan should have a lower rate and a monthly payment that fits within your budget.
Shop Around And Compare Loan Options
You can get debt consolidation loans from many lenders and financial institutions.
Bank loans are the best option for those with high credit scores. Customers with an existing banking relationship are eligible for a better interest rate on a debt consolidation loan.
Credit unions are member-only, non-profit organizations that offer services similar to a bank. They often offer lower rates than traditional banks to borrowers with complicated credit histories. A debt consolidation loan from a credit union requires a hard inquiry with your application, which can cause your credit score to dip temporarily.
Online lenders offer a range of services. Many online lenders also let you ‘prequalify’ for a debt consolidation loan. Additionally, you can compare different rates & terms without impacting your credit score.
When choosing a lender for debt consolidation loans, consider companies that offer direct payment to creditors. After your loan is closed, the lender will send your loan proceeds directly to your creditors without any additional costs – no extra fees are necessary.
Take note of other features that make your decision easier. These might include options like having your payments reported to all major credit bureaus and credit counseling courses.
But above anything else, the loan you choose should be affordable. No unique options or features will beat a loan with a reasonable interest rate and monthly payments you can make.
Advantages of a Debt Consolidation Loan
All told, debt consolidation can make life easier by eliminating multiple payments and lowering your overall expenses. Taking out a loan to combine numerous debts might not seem like a wise idea, but it can help you in the long run. By combining all of your debts into a debt consolidation loan, you’ll save money on interest rates and have only one monthly payment to make. Plus, having just one loan could improve your credit score by reducing the chances of you making a late payment or missing a payment entirely. And, for those trying to become debt-free, debt consolidation can help you pay off your debt faster. Keep in mind that debt consolidation typically leads to a longer loan term, so it is vital to make a point of paying your debt off as soon as possible.
Disadvantages of a Debt Consolidation Loan
On the other hand, a debt consolidation loan does come with a few cons. Loan providers will charge origination fees, balance transfer fees, closing costs, and annual fees for their services—all of which can add up quickly. Additionally, your new interest rate can be deceiving. Even though it may be lower, the life of the loan may cause you to pay more interest than your original loan ultimately. As a borrower, be sure to understand the terms and the actual cost of any debt consolidation loan before accepting it.
What is Debt Settlement?
Debt settlement (also known as debt relief) takes a different approach to debt than consolidation. When you go through debt settlement, you’re asking one or more of your creditors to accept less than what you owe. If you and your creditors reach an agreement, you will pay the settlement amount in a lump sum or a series of installments. Creditors are legally bound to accept this arrangement. This process allows the creditor to recoup at least some of the money owed. It also can help the borrower improve their credit and avoid filing for bankruptcy.
How Debt Settlement Works
Anyone can ask for a settlement with a creditor. But, most debt settlement success comes with the help of debt settlement companies. A debt settlement company will contact your creditors and act as your representative to negotiate a lower balance. These companies charge a fee for their services; usually some percentage of the money they saved on the debt settlement.
The debt settlement company may try and negotiate a less hefty amount with your creditor. As they negotiate, some companies require you to make regular deposits into an account under your control but administered by a third party. The money held in this account goes towards the debt settlement.
The Risks of Debt Settlement
There are some drawbacks to debt settlement that you should be aware of before enlisting the services of a debt settlement company.
Debt settlement can take time, and there is no guarantee that the process will settle all your debts. After working with a company for as long as a year, it may turn out that your creditors will not agree on a settlement number. Moreover, most creditors won’t even begin negotiating with you until the account becomes past due. The process will continue to cost you money as long as it draws out—either in service fees, required escrow payments, or both.
Even if you do reach a settlement, your action will not clear your credit report as a typical closed or “paid in full” account, and therefore will not be as positively impactful. And the action will stay on your credit report for at least seven years. So, even after you go through debt settlement successfully, your debt will remain with you for a while.
As you can see, some of the risks are relatively serious. Debt settlement is not a method that you should try without professional advice. If you want to use debt settlement, make sure you find an experienced and reputable company that follows all the laws and regulations.
How To Improve Your Debt Management
Debt consolidation and debt settlements are not a fix-all. These options merely simplify payments; they don’t address any underlying financial habits that led to those debts in the first place. Many borrowers who take advantage of debt consolidation or debt settlement find themselves in deeper debt because they didn’t curb their spending and continued to build debt.
As you settle or consolidate your debt, either process creates an excellent opportunity to improve how you handle your debt. There are tons of tactics, tools, and credit counseling services that can assist. However, here are three basic steps you can take on your own as soon as possible.
Know How Much You Owe
Create a detailed list of all your debts. Include the total amount of the debt, the monthly payment, due dates, and interest rates. You can also use your credit report to confirm your accounts. Having all your debts in front of you will allow you to see your complete debt picture.
Pay Your Bills On Time
The more you miss payments, the higher your interest rate and finance charges will be. This will make it harder to pay off your debt. This is because you will need to pay a late fee for every payment you miss. If you miss two payments in a row, your interest rate and finance charges will increase.
Create a Budget
If you’re new to budgeting, start simple. Compare your monthly living expenses with the number of your earnings. It can help you make some decisions that will help you eliminate wasteful spending and put money towards paying bills.
Debt consolidation and debt settlement are strategies consumers use to get out of debt. The main difference between the two is debt consolidation incorporates the debt into one fixed monthly payment. In contrast, debt settlement only takes care of the highest interest rate and leaves the rest of the debt intact.
Both attack your debt differently, but they share one important trait—moving your debt closer to zero. Any debt management plan can help you get back on track. It will lower the amount of interest you are paying on your debts and make it easier to repay them over time. You can also use either to lower your monthly payments and set a realistic timeline for getting out of debt altogether.
The best choice for you will depend on many factors, but ultimately, either one will positively impact your financial life.
Which debt management plan is right for you?